Valuation methods - for Mergers and Acquisitions

Valuation approaches are the basic methodology of evaluating a target business for acquisition. The four basic approaches to valuation are as under:

 

1.     Asset based approach

2.     Balance sheet or income based approach

3.     Market value based approach

4.     Comparable transaction approach.

 

1.     Asset based approach:  Essentially this approach considers the fair value of a company’s (or firm’s) assets minus the liabilities that have accrued. This approach commonly uses either the asset accumulation method or the capitalized excess earnings method. The first method establishes the fair market value of tangible and intangible assets (including intellectual property rights, key customer contracts and strategic partnerships) and subtracts from this value, the value of recorded and contingent liabilities (including legal court cases, tax exposure and environmental compliance costs). The resulting value is the value of the business. The second method uses net tangible value of assets and adds them up with excess earnings and good will.

 

a.     Advantages:

                                          i.    The key advantage of this approach is that there is easily available data on assets. The valuation therefore can be pretty straightforward.

                                        ii.    This approach is most useful when evaluating businesses which have large tangible investments in land, property and machinery etc.

                                       iii.    It allows for adjustments in fair market value- either up and down.

                                       iv.    It is particularly helpful when there is only a brief record of a company’s or firm’s earnings.

b.    Disadvantages:

                                          i.    It may understate the value of intangibles like intellectual property or business good will.

                                        ii.    It does not track the future of earnings either up or down.

                                       iii.    A balance sheet can be misleading in terms of exhibiting all assets.

 

2.     Balance Sheet or Income based approach: This method attempts to put a value on the target business by analysing its ability to generate the requisite economic benefits for its owners. It takes estimated future earnings of an equity interest and quantifies its net present value. It looks at the target company’s net cash flow and capitalizes, multiplies or discounts the same. The most famous method deployed by this approach is the Discounted Cash Flow Method. This method establishes a discount rate i.e. a rate of return which would make an acquisition economically beneficial. Another method deployed by this approach is the Capitalization of Earnings Method which takes a target’s discretionary cash flow and divides it by the capitalization rate i.e. the rate of risk associated with the said benefit. Capitalization rate is arrived at by subtracting long term growth rate in business earnings from the discount rate. A third method is the Multiple Method and uses seller’s discretionary cash flow. Here seller’s discretionary cash flow is multiplied with a composite valuation multiple based on industry/business comparison.

 

a.     Advantages:

                                          i.    The biggest advantage is that it is a widely recognized and credible method of valuation.

                                        ii.    It is useful in analysing companies at various stages and of various natures and is based on in certain cases a comparison.

                                       iii.    It comes to a valuation even without there being a market.

b.    Disadvantages:

                                          i.    It relies on projections which are largely hypothetical and based on predictions.

                                        ii.    Too many variables are in play when determining a composite multiple or a discount rate.

 

3.     Market value based approach: This approach looks current market price per share of a company if it is publicly traded or if an IPO is filed. This price is then multiplied with the number of shares outstanding. The actual price paid by the buyer in this case turns out to be higher because the buyer usually has to account for a premium. Another variant of this approach is to look at historic similar sales.

 

a.     `Advantages:

                                          i.    It is reasonably straightforward in terms of calculation.

                                        ii.    It is based on real data i.e. share price.

                                       iii.    It is not based on hypotheticals.

                                       iv.    It can help the target establish a substantial market value.

b.    Disadvantages:

                                          i.    It is usually only beneficial when the target is publicly traded.

                                        ii.    It is usually not a good indicator when the target’s stock is thinly traded.

                                       iii.    It may overstate the value of the stock.

 

 

4.     Comparable transaction approach:  Comparable transaction approach compares previous transactions of companies which are similarly placed in the market i.e. the valuators look at similar acquisitions of companies with similar industry, earnings and business models. Under this approach, the revenue multiple or EBIDTA multiple is utilized. EBIDTA is Earnings before Interest, Taxes, Depreciation and Amortization. The buyer usually organizes a multiples table which lists a selection of previous valuations in the said industry. These are usually similar or comparable companies with similar market capitalization. This table is then used to arrive at a value that the buyer will be willing to pay for the target.

 

a.     Advantages:

                                          i.    This approach deploys simple straight forward calculations based on real public data and empirical evidence.

                                        ii.    It does not depend on subjective data or future forecasts.

b.    Disadvantages:

                                          i.    It is not always easy to determine what companies are comparable.

                                        ii.    It is extremely hard to obtain data of transactions with respect to private companies.

                                       iii.    Requires considerable adjustment of prices etc when considering comparable data over a longer period of time.

                                       iv.    It is not flexible.

                                         v.    It does not take into account – on its own – other factors such as future benefits etc.

                                       vi.    Finally the veracity of the data is always a question mark.

 

 

It is important to note that these approaches are seldom used as stand-alone but rather a hybrid approach is adopted in valuation. Of the above, the income approach especially vis a vis Discounted Cash Flow Method is used in conjunction with comparable transaction approach, especially the use of EBIDTA multiple as well as the revenue multiple often together to determine the business health of the target.

Broad categories of mergers

The three broad categories of mergers and acquisitions are:

 

1.     Horizontal merger/acquisition

2.     Vertical merger/acquisition

3.     Conglomerate merger/acquisition

 

1.     Horizontal merger/acquisition:

 

This happens between two companies or businesses placed in the same market and providing the same products or services. An example of a horizontal merger/acquisition is the Mobilink-Warid merger/acquisition. The motives of companies entering into a horizontal integration are any or all of the following:

 

a.     Economies of scale:  By joining together and forming a bigger company gives the new entity or the expanded entity greater economies of scale. These are the cost advantages that companies obtain due to size, output, or scale of operations such as production etc.

 

b.    Synergies: By combining sales channels for example, companies can increase their outreach and become a larger player.

 

c.     Market share and growth: Horizontal mergers are one way of improving market share. Similarly the businesses merging may conclude that together they can grow better and because of a better market share will be in a stronger position to influence the market.

 

d.    Eliminating redundancies: Two companies would have two finance departments, two legal departments, two procurement departments etc. Mergers and acquisitions can help eliminate redundancies. Obviously this is bad news for the employees but overall by eliminating redundancies, companies become more profitable.

 

e.     Filling the product range/product line: In some cases an acquisition of this kind can help fill a product range. So for example in Mobilink-Warid merger/acquisition, the attraction for Mobilink is the 4G LTE spectrum which it does not have on its own. Mobilink would be able to provide 4G LTE services to its users ultimately without having paid excessive amounts for 4G unlike ZONG for example which has paid a large amount for its 4G spectrum.

 

 

2.     Vertical merger/acquisition:

 

Vertical mergers/acquisitions happen between two companies which – while in the same industry- are in a buyer-seller relationship.  Backward vertical integration would be a company merging with or acquiring its supplier. Forward vertical integration would be a company taking over a retailer, wholesaler or distributor. The main reason for a vertical integration is to ensure either that the supply lines are reliable, or to ensure greater control over distribution networks and sales channels. A famous example of this kind of merger is the one that occurred between Time Warner and AOL in 2000.  Time Warner creates content and AOL was the largest internet dissemination portal at the time. Eliminating redundancies also occurs to a certain extent in this kind of merger. Similarly it may be useful in order to deploy certain capacities which previously were not available. This is what happened with British Petroleum’s 2003 acquisition of Russian TNK company which had oil reserves but little refining ability or retail marketing for the western market.  BP took over TNK and it was a win win for both sides because BP got access to oil reserves which it could then utilize in its refineries and sell through its sales channels.

 

 

 

3.     Conglomerate merger/acquisition:

 

The conglomerate merger/acquisition usually happens between two unrelated companies. A great example of this kind of merger was Phillip Morris’ 1985 acquisition of General Foods i.e. a tobacco giant taking over a diversified food company. Another example was the 1959 acquisition of Avis, Sheraton Group and Continental Baking Company by International Telephone and Telegraph Corporation – which were completely unrelated. The reasons for this sort of merger/acquisition are as under:

 

a.     Breaking through cyclical and seasonal demand: By far the greatest reason for a buyer acquiring an unrelated business is diversification, especially when its own product is of a cyclical or seasonal nature. By breaking into a new market, it ensures that it is constrained by a particular season or a particular kind of demand.

 

b.     Regulatory pressures:  Regulatory pressures in one industry might force a buyer to look for alternatives in a market or industry that is not as heavily regulated. This is a very common reason for conglomerate merger/acquisition.

 

 

A slight variation on this kind of merger is a concentric or congeneric merger. In this case the two companies are in the same industry but serve different subsets or markets within it.  A merger between a WLL broadband company with a cellular mobile company would be an example of this congeneric or concentric merger. Similarly one may argue that Microsoft’s acquisition of Nokia (to enter into the smart phone market) was this kind of acquisition though it has turned out to be a colossal failure.

 

c.     Product line extension/market extension: Extension of product line or market extension – as mentioned above- may be the rationale for a congeneric or concentric merger.  Here too a product line hole may be filled by acquiring a company that has the requisite product or intellectual property. Google and Yahoo’s acquisitions of online app companies are great examples of such mergers/acquisitions. Proctor and Gamble’s 2005 acquisition of Gillette for men care products was done to fill a hole in its product line.

Mergers and Acquisitions - Why Companies acquire other companies and why they don't.

The reasons why companies decide to acquire or merge with other companies are manifold and are as follows:

 

1.     Diversification especially for cyclicality reduction and to ease regulatory pressures: The idea for any business is to inject new blood and diversify. Diversity and product range plays a critical part in any merger or synergy. A buying company therefore may be able to break from a cyclical or seasonal market by acquiring a company outside of its product range, thereby diversifying its product range and evading profitability fluctuations. Similarly a business may operate in a stifling regulatory environment and might want to acquire a company or a business which operates in a relatively relaxed regulatory environment. This would allow greater flexibility in operations.

 

2.     Business Model: The business model of the company being acquired may be significantly more attractive. It may offer fewer benefits or may not be hindered by unions. The acquiring company may not be in a position to replicate that model and therefore may choose to acquire it altogether.

 

3.     Intellectual Property, Licenses and Rights: A very good reason for acquisition is usually to acquire intellectual property and/or licenses and rights that the company being acquired might own or enjoy. An example of this would be Mobilink’s recent acquisition of Warid which is being done for the large part to acquire the Warid spectrum which allows for 4G LTE operations, giving Mobilink an edge. Same holds true for trademarks, copyrights and patents in other cases. 

 

4.     Market Share and Growth: One of the major reasons and usually the riskiest one is the attempt to increase market share through acquisition. This usually happens when the companies are situated in the same market. A variant of this is to achieve market growth by acquiring a company in a market that is growing faster. The first of these is risky because it is open to regulatory challenges including competition challenges.  The second variant is very similar to diversification explained above.

 

5.     Production Capacity, Product Range and Product Line: Another common reason for merger and acquisition is to either increase production capacity or fill a hole in a product line.  For example a mobile telephony company may seek to acquire a broadband WLL company to ensure that it can also offer a dongle device as part of its product range. Similarly a fixed line telephony company may acquire a mobile telephony company to ensure that it can also cater to the mobile market. Another related example of this is Microsoft’s acquisition of Nokia. Microsoft wanted to take over Nokia to fill a hole in its product line i.e. smartphones. Obviously the acquisition turned out to be a colossal failure in strategy but nevertheless the idea behind it was sound.

 

6.     Sales Channels and other synergies: Another reason may be that a company might have effective sales channels and the other acquiring company may want to utilize these effective sales channels. It is not unusual for parent companies and subsidiaries to share sales channels. PTCL for example uses the sales channels of PTML Ufone which is its 100 percent owned subsidiary. So synergies in sales channels may actually be a very good reason for two companies to merge or one company to acquire another.

 

7.     Vertical integration: A company may acquire a supplier to ensure its supply lines are secured. This would be an example of backward vertical integration. In other instances forward vertical integration is also possible where a company may acquire its customer or a distributor.

 

8.     Local market expertise: A foreign company may want to acquire a local company to enter into the local market. Numerous such examples exist across the border in India, where companies have been acquired by foreign companies to acquire expertise and skills to operate in the Indian market. Such an acquisition or a merger allows a foreign buyer to acquire instantly the local market skill and expertise including knowledge of local customs, laws and obstacles germane to language and other cultural barriers.

 

9.     Defensive reasons and ulterior motives: Sometimes a company may acquire another company to become so disproportionately large that its acquisition by a third company would render it to challenges under the anti-trust and competition laws of the country. Another reason, usually an ulterior motive would be, that the management thinks having a larger company will mean greater executive compensation. This is usually a bad reason to acquire and often leads to unmitigated disaster.  Corporate greed is never a good reason for a merger or an acquisition.

 

10.  Target company’s reasons for being acquired: Equally important are the reasons for a target company or business (i.e. company that is being acquired) to allow itself to be acquired. These are:

 

a.     Anemic Profits and Survival: Usually if a company has little or no profits it would want to be acquired so as to survive.

b.     Competitive environment and Patent expiration:  A company may want to be acquired because it cannot face the aggressive competition by its competitors without extra help.  Another reason may be that a company may find itself in a situation where its exclusive patent is expiring and it may not be able to compete without extra help.

c.     Rapid growth or conversely stalled growth: In both cases a company may want to be acquired. In the event of rapid growth, to sustain working capital and in the event of stalled growth to further maximize profits.

d.    Shareholder pressure:  Shareholders may press for acquisition where a buyer is willing to offer complete liquidity to a group of shareholders.

e.     Technological obsolescence:  The technology used by a company may be obsolete or nearing obsolescence. It may want to be acquired so that the buyer may use it to convert it to new technology. In some ways we have seen such acquisitions in the print media market where newspapers have been taken over by technology companies who then convert existing newspapers into online portals.

 

The aforesaid reasons do not constitute an exhaustive list.

 

There are many reasons, administrative, legal and others, which may deter a company from acquiring or being acquired. These are as follows:

 

1.     Competition law concerns:  A merger may lead to anti-competitive and anti-trust challenges. The newly merged entity may become too big for its own good and such a merger may not be approved by the competition body or regulator. An excessively large market share or in Pakistan’s case any inhibition of competition when the merging parties cross thresholds defined by the Competition Act 2010 may automatically be challenged and may not be approved after the two review process.

 

2.     Regulatory concerns:  In certain industries, such as telecommunication in Pakistan, the regulator plays an important role in determining pricing structure and the role of a significant market player. For example the on cards merger/acquisition of Warid by Mobilink is still going to have to overcome regulatory hurdles and approvals.  Failure to get regulatory approvals for mergers can lead to 

 

3.     Surprises resulting from poor due diligence: This happens quite often in mergers and acquisitions. Nasty surprises such as an incomplete audit or failure to get an undertaking or overlooking a key balance sheet can have its own impact. Accurate due diligence would usually show the financial and legal health of an entity. An acquiring concern should not touch an encumbered target with a ten foot pole. It is not in a buyer’s interest to assume any liabilities which it is unaware of. 

 

4.     Lack of common vision: A lack of common vision between two managements may be a big deal breaker. A lack of common vision would mean that a convergence between the two managements would be impossible and therefore the merger or acquisition would be doomed from the start.

 

5.     Complex, Costly and Convoluted: Mergers and acquisitions are often very complex, are definitely very costly and extremely convoluted with regulatory codes and rules involved. The entire process requires a commitment and a spirit of fairness which is often lacking between two aggressive negotiating entities working at cross purposes. 

 

6.     Value reduction risk: Empirical evidence suggests that acquisition transaction often destroys value i.e. the acquiring entity or the merged entity is ultimately valued less than the two entities previously were in sum. Ultimately it is the opportunity cost of advantages gained from the merger or acquisition. Would that opportunity cost be acceptable?  Would it be offset by significant gains?  This is ultimately the call a merging or acquiring entity has to make.

 

7.     Seller’s acquisition risks: By putting itself out there for acquisition, a selling target exposes itself. For example a competitor may enter the bidding process only to be able to conduct due diligence on key and significant parts of the seller’s operations. It can obtain pay rates, HR data, proprietary information, key operating and engineering information, and product ranges both current and in pipeline.  Usually a confidentiality agreement is used to protect against this eventuality but their effectiveness is limited.

 

8.     Misdirected objectives:  An acquiring company may fail to pinpoint exactly what it wants out of the target acquisition. It may want the HR culture or work ethic but that may not happen simply because it takes over an entity. HR culture is not acquired but is embraced.

 

9.     Alternative of building instead of buying: An acquiring company may be acquiring a target because it wants to buy innovation and news ideas. However it may be cheaper for the acquiring company to actually invest in its own research and development which would lead to more organic innovation and add value to the company.

 

10.  Poor Governance, confusion and lack of leadership: In either merger or acquisition, there comes an extended period of poor governance because new management is slow in implementation of the plan or is unable to cope with fast changing situation on the ground. Poor governance causes confusion and is usually coupled with a lack of leadership. This is one of the major reasons to avoid a merger or acquisition situation because the risk is that residual benefits of any such acquisition would be squandered by either poor governance, infighting or confusion about the chain of command.